Europe's monetary union has become an instrument of deflation torture … If the purpose of the euro was to bind Europe's tribes together and serve as catalyst for political union, EU elites must have been chastened by the outpouring of anti-German feeling in the Greek parliament last week. The Left called for war damages for Axis occupation and accused German banks of playing a "wretched game of profiteering at the expense of the Greek people." Mainstream New Democracy was no nicer. "How does Germany have the cheek to attack us over our finances when it has still not paid compensation for Greece's war victims? There are still Greeks weeping for lost brothers," said ex-minister Margaritis Tzimas. This is deeply hurtful to Germany, a vibrant democracy that has played its difficult part in Europe for 60 years with dignity. No country could have done more to overcome its demons. It has paid the EU bill, and paid again, rarely grumbling. Yet a decade of monetary union has created such a wide and self-perpetuating gap between North and South that everything in EU affairs is poisoned. German-Greek relations are the worst in my lifetime. – UK Telegraph

Dominant Social Theme: The EU is worth preserving and will triumph.

Free-Market Analysis: We wanted to write about the irony of the anger that is rising in Euroland, and lo and behold, the UK Telegraph makes the pertinent observation. What supposedly began as a way to generate comity between various European countries is now, as euro-currency-rules bite, causing ongoing friction between Greece and Germany. But this cannot be the only spat as there are numerous other countries in roughly the same situation as Germany (the so-called Pigs). Here's some more from the article:

EMU is slowly suffocating boom-bust states trapped in debt deflation, acting in the same perverse and destructive fashion as the Gold Standard in the 1930s. Gold rules were simple: surplus states loosened, deficit states tightened. This preserved equilibrium. World War One shattered the system. The US was not ready to take the guiding role from Britain.

The dollar was undervalued in the 1920s. America ran vast surpluses, like China today. So did France, which re-pegged too low. Both drained the world's bullion. Yet neither loosened: the Fed because Chicago liquidationists ran amok; the Banque de France because its post-War brush with hyperinflation was still fresh. Adjustment fell entirely on deficit states such as Britain. They had to tighten into the downturn, feeding debt deflation. Global demand imploded on itself until the entire system collapsed. In the end, the US and France were victims of their obduracy, but that was not clear in 1930, or 1931, except to Keynes.

This is the story of Euroland. The North is in surplus, the South in deficit. Germany's current account surplus was 6.4% of GDP in 2008, Holland's 7.5%. Club Med deficits topped 14% for Greece, and 10% for Iberia. The gap has narrowed since but remains structural. This is an intra-EMU version of China's surplus with the West. But at least China is doing something about it with a fiscal blitz and 30% growth in the money supply.

Germany has banned budget deficits, implying a fiscal squeeze next year. IG Metall has agreed to a pay freeze, undercutting Spanish and Italian unions yet again. How can Club Med close a 30% gap in unit labour costs against deflating Germany? Brussels is enforcing an EU-version of Pierre Laval's deflation decrees in 1935, the policy that tipped France's Third Republic over the edge. It has ordered Greece to cut the deficit by 10% of GDP in three years or face the whip under Article 126.9. Spain must squeeze 8%. France next?

We find some of the above a little confusing, based on what we understand of monetary history. The Telegraph is by no means a hard-money publication, and the above article even quotes John Maynard Keynes approvingly. According to the monetary history we have read and understood, however, the American Federal Reserve DID inflate wildly in the 1920s – so much so that Roosevelt confiscated gold for fear that the American public would discover that the legal linkage between gold and the dollar had been broken. It seems fairly obvious (to us, anyway) that a decade known as the "Roaring 20s" with a stock market boom of inordinate proportions must have involved a "loose money" policy that included inflation of the money supply. Here's the neoclassical argument as summarized by Wikipedia:

Austrian theorists who wrote about the Depression include Hayek and Murray Rothbard. Rothbard wrote "America's Great Depression" in 1963. In their view, the Great Depression was the inevitable outcome of the easy credit policies of the Federal Reserve during the 1920s. Since its enactment in 1913, the Federal Reserve had served as the central bank of the United States. The Federal Reserve effectively regulated the amount of credit private banks could issue by providing overnight loans and strict reserve requirements.

The problem with this policy is that the reserve rate and interest rates were centrally decided then uniformly applied to all banks. This central mechanism of interest rate and fractional reserve rate determination stands in stark contrast to market mechanisms distributed and specific to each bank. Uniform central bank policies allowed banks with poor lending policies to have easy access to credit-as easy as conservative banks. Austrian theorists hold that the key cause of the Depression was the expansion of the money supply in the 1920s that led to an unsustainable credit-driven boom. In their view, the Federal Reserve, which was created in 1913, shoulders much of the blame. By the time the Fed belatedly tightened in 1928, it was far too late and, in the Austrian view, a depression was inevitable.

What the Telegraph is proposing is not a Keynesian explanation for the Roaring 20s but a Gold Standard explanation – which may actually have more relevance to the Great Depression than the Roaring 20s. In any event, EU/euro rules apply to all countries in the eurozone. The EU is not apt to loosen monetary policy to accommodate Greece, or other profligate nation (Pigs, as they are called). As we have pointed out previously the result will be a grinding down of those countries in the eurozone that are "weakest." Here's George Soros writing in the Financial Times, recently:

The construction is patently flawed. A fully fledged currency requires both a central bank and a Treasury. The Treasury need not be used to tax citizens on an everyday basis but it needs to be available in times of crisis. When the financial system is in danger of collapsing, the central bank can provide liquidity, but only a Treasury can deal with problems of solvency. This is a well-known fact that should have been clear to everyone involved in the creation of the euro. Mr. Issing admits that he was among those who believed that "starting monetary union without having established a political union was putting the cart before the horse".

The European Union was brought into existence by putting the cart before the horse: setting limited but politically attainable targets and timetables, knowing full well that they would not be sufficient and require further steps in due course. But for various reasons the process gradually ground to a halt. The EU is now largely frozen in its present shape. The same applies to the euro. The crash of 2008 revealed the flaw in its construction when members had to rescue their banking systems independently. The Greek debt crisis brought matters to a climax. If member countries cannot take the next steps forward, the euro may fall apart.

Germany is actually the country most on the hook here. The Germans sought the European Union because a single currency provided stable purchasing power for the country's industrial might. But in retrospect the solution was not a real one as the weaknesses in southern economies remain. Thus, Germany got a stable currency but at the expense of pushing trouble further down the road. And now trouble knocks.

After Thoughts

Germany's leaders are faced with a quandary. Germany and France are the leaders of the EU, but Germany will be expected to pull the main weight when it comes to an EU bailout. Yet it is highly unlikely that the German electorate will be very happy with this state of affairs. At the same time, political realities are such that EU leaders will not suddenly be able to seize power and simply dictate economic terms to the Pigs. They may be able to instruct lawmakers, but it is the Street in Italy, Portugal, Spain, etc. that will ultimately dictate what is feasible. Those with investments in the EU, or who wish to make a currency play on the euro will have to consider what is increasingly a serious dilemma for those behind the EU project.

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